Mergers And Acquisitions 2007
University of New South Wales
Faculty of Law
Centre for Continuing Legal Education MERGERS AND ACQUISITIONS 2007
24 October 2007 Opening Commentary
by Justice RP Austin
With his usual efficiency, Christopher Lemercier has given me access to the papers for this morning's seminar, so far as they have been made available to him. As one would expect, the conference program identifies some critically important issues confronting M & A lawyers today.
In the first session, David Friedlander of Mallesons will consider developments in international mergers and acquisitions, including the prospects for private equity transactions, and global trends in light of the tsunami effects of the US sub-prime mortgage crisis.
Leon Pasternak of Freehills has prepared a wide-ranging paper canvassing the responsibilities of directors and their advisers. Not only does he survey statutory and case law and guidance notes provided by the Takeovers Panel. He also offers some practical steps and tips for managing conflicts of interest.
Leigh Brown of Minter Ellison will speak on developments in mergers by scheme of arrangement, including trusts. Several problems have been identified in recent Federal Court and Supreme Court decisions that will no doubt be canvassed.
Karen Evans-Cullen of Clayton Utz will discuss some developments concerning the Takeovers Panel. She will review the Panel's track record and consider the amendments that took effect earlier this year concerning its powers, in response to the Glencore cases ((2005) 54 ACSR 708; (2006) 56 ACSR 753). She will also review the Alinta decision in the Full Federal Court ((2007) 62 ACSR 196), from which the High Court has recently heard an appeal, reserving its judgment. She will ask, "where to now for takeover disputes?" She will also consider the Panel's draft Guidance Note on derivatives.
In my opening commentary, I propose to raise some subjects pertinent to the first three papers, offering some necessarily general and tentative observations on each of my selected subjects. I shall talk about:
- the short-term future of private equity transactions;
- executive directors of the target participating in a bidding consortium;
- some current issues in merger schemes.
I then want to make a few remarks about the current state of Australian statutory company law and in particular, what seems to me a deplorable trend in the drafting of legislative amendments. I have decided not to say anything about the subject matter of Karen Evans-Cullen's paper, principally because she addresses issues that have been argued before the High Court but not decided. My views about the Alinta case in the Full Federal Court, and the Corporations Law Amendment (Takeovers) Act 2007 enacted in response to the Glencore decisions, are set out at length in Chapter 23 of Ford.
The short-term future of private equity transactions
Recently I was responsible for organising the second Supreme Court/Law Society Corporate Law Conference in the Banco Court in Phillip Street. The book containing the edited conference transcript, and an excellent essay on private equity by my young academic colleague, Andrew Tuch, will become available for conference participants, and for sale to others, from this coming Friday through the Ross Parsons Centre at Sydney Law School. It is called Private Equity and Corporate Control Transactions, edited by me and Andrew Tuch.
I mention it here not to promote sales, for the book will sell itself, but rather to tell you something I found striking about the remarks of the speakers. When we decided to hold the conference, private equity was rampant and seemed unstoppable. Myer had fallen, Coles was in negotiation and Qantas was under offer. Internationally, transactions of staggering size were being announced. Globally private equity investment had increased from just under $US200 billion in 2001 to over $US800 billion in 2006. It was party time for M&A lawyers. Then came the US sub-prime mortgage crisis, the collapse of two Bear Stearns funds, and widening ripples in the credit and equity markets. I wondered what our speakers would be able to say about private equity, in the prevailing turbulence as at 28 August 2007.
Strikingly, the unanimous verdict of the speakers was that private equity transactions would continue as a significant force in mergers and acquisitions. Future transactions would be different and in particular, there would be a more commercial approach to the pricing of risk. But private equity would still be there. As David Gonski concluded:
"For so long as we have extensive disclosure requirements and a great deal of law and market conventions applicable to listed public companies, privately owned businesses will be able to take substantial advantage of the system".
And so the legal issues posed by private equity transactions - for instance, problems relating to whether to prefer schemes to takeover bids, whether to accept no-shop and no-talk clauses and break fees, whether to disclose a private equity approach to the market, and how to deal with participation by management of the target in the buying consortium, issues addressed in the August conference and today, are very much worthy of careful consideration.
Executive directors of the target participating in a bidding consortium
Suppose that a bidder, typically private equity, invites key executive directors, including the chief executive, to join the bidding consortium, with an offer of equity participation as well as greatly enhanced remuneration if the bid succeeds. Is there a legal problem for the executive directors? How should the rest of the target board respond?
These questions have received intense attention in recent times, in light of various transactions that I shall not discuss. Leon Pasternak addresses the issues in his paper for today's conference. Like many other commentators, he speaks of "managing" conflicts of interest and, following the lead given in the Takeovers Panel's Guidance Note, he proposes some protocols and practical advice for conflict management in these situations.
But of course, as Leon is aware, Guidance Notes by the Takeovers Panel, worthy though they are, are of the limited significance. They only assist if the question is whether the Panel will exercise a discretion vested in it under the Corporations Act. They do not purport to affect the content of the statutory and equitable fiduciary duties of executive directors. The Panel itself acknowledges, at [22] of Guidance Note 19, that compliance with its protocols may not be adequate to discharge the duties and responsibilities that apply.
Guidance as to the law is to be obtained from the text of the legislation and the cases. In Australia, unlike the United Kingdom, the statutory provisions are not exclusive, and so the general law of fiduciary duties may have an application where the statute does not.
Recently two leaders of the Australian bar, one a former Federal Court judge, have given presentations as to the content of the duties in issue. They have spoken with substantial but not complete consistency.
The first presentation was a written paper by Neil Young QC, delivered at a Law Council Workshop in South Australia on 21 July 2007. Mr Young carefully reviewed the general case law on fiduciary duties and the various statutory provisions that affect the position of the executive director.
Referring to Furs v Tomkies (1936) 54 CLR 583 and other cases, he said (at [56]):
"When these principles are translated to the private equity context, it becomes plain that senior executives of the target company cannot, consistently with their fiduciary duty, agree to accept substantial incentive or equity packages from a bidder without approval of the target company's shareholders. If they do, they will breach their fiduciary duties and will be bound to account to the target company for any profits they make. Even if executives in this position disclose all of the details of their incentive packages to the target company's board of directors, that would not afford an answer to their breach of fiduciary duty. The fully informed consent of the target company's shareholders would be required to authorise or ratify private incentive or profit arrangements of this kind."
Mr Young also expressed the opinion (at [99]) that, in addition to the general law fiduciary duty, if a senior executive of the target agrees to accept a financial package from the bidding consortium as an inducement for that person to remain on after the acquisition is completed, the case potentially falls within s182, which prevents an officer from improperly using his or her position to gain an advantage or cause detriment to the corporation.
He contrasted Australian law with US law, under which it is thought that directors can usually overcome conflicts by disclosure and abstentions. He said (at [102]):
"Under Australian law, the true position is that, in some instances, a declaration of the conflict, full disclosure of all relevant circumstances and abstention from discussion and voting may be sufficient for a director to discharge his or her obligations. In other instances, it will not; the approval of the company in general meeting may be required, the director may have to take steps to eliminate the conflict, or special circumstances may require a director to take positive steps to protect the company (e.g. by recommending a particular course of action)."
Tom Bathurst QC addressed these issues in his presentation to the Supreme Court/Law Society Conference on 28 August 2007. He said (at p 79):
"Members of management who may benefit from the proposal either by incentives to stay on or by encouragement to participate in the bid, are plainly in a position of conflict in making recommendations based on the indicative price, in making recommendations as to whether an exclusivity period is appropriate and, subsequently, recommendations on whether an offer should be accepted, its terms or any break fee. To avoid that conflict arising, it will be necessary, first, for the management concerned to disclose fully and frankly details of the negotiations with the private equity bidder, and thereafter to take no part in the decision-making process on behalf of the company. The negotiations and ultimate decision must be left to an independent board, taking such independent expert advice as it regards as desirable."
The position is different, in his view (at 80), if management actually solicits the private equity bid: "What they cannot do, however, is promote a bid as a means of advancing their own position. … Quite apart from the general law obligations, such conduct could involve an improper use of their position prohibited by s 182 of the Act and an improper use of information prohibited by s 183."
Referring to Furs v Tomkies and other cases, he said (at 80): If an existing employee is offered shares or other incentives to participate in the bid or to stay on with the company after the transaction is completed, it seems to me that there is a real prospect that he or she is improperly profiting from his or her position as an officer of the company."
On the question whether conduct of this kind is capable of ratification by an independent board or whether ratification by the shareholders is necessary, he referred to Queensland Mines v Hudson and said (at 81):
"Where an independent board reaches the conclusion that a transaction is in the interests of shareholders, and that a necessary incident of the transaction is that the benefits to be provided to the officer necessary to keep the officer there and to ensure that the bid is made and proceeded with in the best interests of shareholders, then in my opinion (but without any certainty) the board's approval would provide the necessary informed consent of the company. The issue, however, remains controversial."
Presumably the board is "independent" only if the executive who stands to benefit from the bid is not, himself or herself, a director.
There is much common ground in the views presented by Mr Young and Mr Bathurst, both of whom emphasised the strict and inexorable character of fiduciary duties. But there are differences on two matters:
- whether executive officers will ever be sufficiently protected simply by making full disclosure to the board and excluding themselves from further involvement in the negotiations on behalf the company;
- whether, if there is an independent board, the fully informed consent of the company can be given by that board or only by the shareholders in general meeting.
As Mr Bathurst observed on several occasions during his presentation, questions of this kind are tested in the courts not at times of readily available capital and booming markets, when everyone is doing well; they are tested when things are going wrong. Inevitably the courts will be asked to pronounce on these matters, and recent difficulties in the markets suggest that this could be sooner rather than later. It would be premature for a judge to seek to anticipate the outcome of such litigation, especially when so much will depend on the facts of the instant case. But it does seem to me that talk about managing conflicts of interest in this situation is at risk of losing sight of the strict standards set by the law. Some conflicts cannot be "managed"; they must be avoided. As Mr Young emphasised in his paper, courts have frequently said that the law demands undivided loyalty from a fiduciary. The question is not whether there is an actual conflict; the question is whether there is a real sensible possibility of conflict. If there is, either the conflict must be eliminated (for example, by the executive director rejecting the offer of benefits) or the proposal must obtain the fully informed consent of the company. The court will be interested to know whether, and if so why, the instant facts are distinguishable from Furs v Tomkies.
Some current Issues in Merger Schemes
The central issues for the court, when it is asked to approve a scheme of arrangement, are constant and readily understandable: does it comply with the law; was it approved on the basis of adequate information by the shareholders acting in good faith; is it sufficiently fair and reasonable that an intelligent and honest shareholder, acting alone, might approve it. Those are always the matters to be addressed by the applicant for approval.
There are, however, some other issues, more or less subsidiary, that attract the attention of counsel and the court, frequently because the issue in question has been raised in a recent decision or line of decisions. In recent cases courts have been concerned with three such issues: credit or performance risk, the acquisition of encumbered shares, and lock-up devices. There is a detailed discussion of these three issues in Ford's Principles of Corporations Law at [24.071]. There is not much more to be said about credit or performance risk and lock-up devices, but the acquisition of encumbered shares is a subject warranting further consideration.
The issue of credit or performance risk is relatively straightforward and does not present any insuperable problem, provided that the issue is recognized and addressed by, for example, setting aside the cash portion of the scheme consideration in a trust fund immediately before the vesting of the shares in the acquiring company.
There was some concern about the court's attitude to lock up devices (such as no-shop and no-talk causes and break fees), especially when Lindgren J in the APN case ([2007] FCA 770) stated some requirements going beyond the Takeovers Panel's Guidance Note 7. But in the Investa Property case the same judge accepted an affidavit to the effect that the arrangements were agreed to by the company following ordinary arm's-length commercial negotiations during which the parties were separately advised by advisers with extensive experience of transactions of that kind.
In my opinion there is still more to be said about the question of acquisition of encumbered shares. In the Webcentral case ((2006) 58 ACSR 742) the court decided that a "no encumbrances" clause (that is, a clause in the scheme stating that the scheme shares would be transferred free of encumbrances) was to be excluded by amendment to the scheme after the shareholders had approved the scheme. The court took the view that the presence of the clause might have given the impression that the interests of holders of security were being adversely affected.
In the Investa Property case ([2007] FCA 1104) the court did not object to a similar cause that was expressed to apply "to the extent permitted by law". The court was concerned that there might be some cases, probably rare, where a third party has an equitable interest in shares (typically as a financier) and the acquiring company has notice of that interest. Lindgren J said he saw no reason why the court should do anything that might give the impression that it was supporting the extinguishment of the third party's equitable interest in such (presumably rare) circumstances. He said that at the very least, before approving a scheme containing an unqualified "vesting free of encumbrances" term, the court would require evidence that the acquiring company had no notice of any third party interests.
There is a live issue as to whether this reasoning imposes an unnecessary restriction on the operation of s 411. The issue is canvassed in Ford. The argument is made there that the principal attraction of a scheme of arrangement, when compared with other methods of corporate reconstruction, is that the court's order implementing the scheme achieves certainty of outcome, an achievement that would be compromised in the case of transfer schemes if the court's order were to be subject to the prospect that the holder of an equitable interest over the transferred shares could assert a claim over the shares in the hands of the acquirer. It would be surprising if the scheme procedure could not extinguish security interests over transferred shares, given that other methods of compulsory acquisition of shares apparently do so.
The future of Australian company law
When I began studying company law in 1967, it would have been accurate to say that nothing in the companies legislation was as important, in the life of companies and their officers, as the major general law decisions of the appellate courts, in cases such as Mills v Mills (1938) 60 CLR 150, Ngurli v McCann (1953) 90 CLR 425 and Furs v Tomkies in the High Court, and Regal (Hastings) v Gulliver [1942] 1 All ER 378 and Boardman v Phipps [1967] 2 AC 46 in the House of Lords. The principles enunciated by the courts in those cases affected day to day management of Australian companies, particularly when management was under stress.
Today it is statutory company law that has the primary day to day impact on corporate activity: statutory formulations of the basic duties of company directors and officers; provisions defining the metes and bounds of corporate fundraising and regulating in detail the provision of financial products and services; prescribing the content of periodic and continuing disclosure including remuneration disclosure; reinforcing accounting and auditing standards and proclaiming rules for auditor independence; regulating corporate acquisitions; creating statutory liability for companies (and ancillary liability for directors and officers) for misleading conduct; and exposing directors to liability for insolvent trading.
The dramatic elevation of the importance of statutory company law carries with it a responsibility for the legislature, the government and its advisers. It is of fundamental importance that statutory laws be clear, simple and knowable. It is strongly desirable, when the law seeks to regulate those commercial activities where time is often of the essence, that the law be understandable in its basic components by business people in their own right, without recourse to lawyers. These things are important because valuable commercial rights are at stake, which can be greatly diminished if the legislature casts a shadow of uncertainty over them.
Admittedly, clarity and simplicity are aspirations that will never be perfectly achieved, because of the complexity of the subject matter and the limits of human ability. But we need to demand, persistently and with force, that modern statutory company law be regularly and systematically reassessed by reference to these benchmarks.
The Corporations Law Simplification Program of the 1990s led to some real achievements in reversing the trend towards longer and more complex legislation. The First Corporate Law Simplification Act 1995 was dramatically successful in reducing the number of registers to be maintained by companies and in slashing through the verbal thicket of the old share buy-back provisions. The Company Law Review Act 1998 (essentially the Second Simplification Act, re-badged after a change of government) was even more dramatic, not merely simplifying language but fundamentally changing the basal concepts in such areas as share capital. But every significant amendment to the corporations legislation since that time (with the single exception of the replacement of the co-operative state system with a national Corporations Act) has added substantially to complexity and, it has to be said, has created obfuscation.
The very mention of the Financial Services Reform Act 2001 will produce moans of despair. It is not just the excessive detail and complexity of the drafting, the devastatingly comprehensive abandonment of the principles of simplification, that causes difficulties; it is also the extent to which the legislative text is affected by regulations and ASIC modifications, adjustments that evidently became necessary because of flaws in the formulation of policy and legislative text.
Then there is the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 ("CLERP 9 Act"). Most M&A lawyers do not have to grapple with the auditor independence provisions, but rest assured that the drafting is every bit as depressing as the FSR Act. As we point out in Ford (at [10 .455]), the statutory language establishes duties in parallel with but different in content from the general law fiduciary duties of auditors.
The drafting of the Corporations Law Amendment (Takeovers) Act 2007 is problematic in some respects, as pointed out in Ford (at [23.600]). But the legislation is generally acceptable, partly because it is short and partly because there was effective consultation with those primarily affected.
On 28 June 2007 we were given another example of the legislative drafter's delinquencies, when the Corporations Legislation Amendment (Simpler Regulatory System) Act 2007 commenced. The centrepiece of this legislation is an attempt to remove the prospectus requirement for a rights issue. But the drafting displays a peculiarly 19th-century understanding of rights issues, and the legislation does not seem to work when it comes to modern variants such as jumbos and RAPIDS. Not only that, but the purported exemption only works if the issue gives the securities exchange a "cleansing" notice that complies fully with the statutory requirements. If something is left out, the legislation gives protection from contravention of one of its provisions (s 727) but not others (ss 723(1) and 734(2)). These problems are explained in detail in the most recent supplement to Ford. Relying on the exemption will require a measure of courage.
But that is not the only issue with the new legislation. The legislation substantially winds back some of the auditor independence provisions that were enacted to give effect to recommendations of the HIH Royal Commission. To take just one example, the two-year exclusion period during which a former audit partner cannot become an officer of the audited client has been re-calibrated to become far less effective. Before the amendment, the two-year period began when the partner ceased to be a partner in the audit firm. After the amendment, the two years is measured from the date of the last audit or half-yearly report in which the partner participated as a professional member of the audit team for the client. If the partner moves out of the audit team for the client at least two years before retiring from the partnership, there is no longer any restriction on joining the client immediately upon retirement, even though the partner has continued to enjoy profit distributions contributed to by the client right up to retirement and would probably have every incentive to support the firm uncritically in his or her new position.
There are questions about the policy foundations for the changes made by this legislation; there are questions about how important shifts of policy were implemented under the guise of simplifying the regulatory system; there are questions about the adequacy of consultation and public exposure of the proposals; and there are questions about the style and efficacy of the drafting. Underlying these questions there is (or should be) a deep concern as to whether legislative drafting of corporate law reform is in the right hands.
One only has to compare the drafting of any of the samples of corporate law reform offered up since the commencement of the Corporations Act, with the drafting of the UK Companies Act 2006, to realise how much scope there is for improvement here. Some of the provisions of the UK legislation are controversial, especially in the field of corporate social responsibility. I do not wish to fuel the fires of that controversy here. I refer, instead, to the statutory restatement of less controversial directors' duties, which is made in the UK Act with an elegance, clarity and simplicity that we would do well to emulate.
We can and should do a great deal better than we have in the corporate law amendments of the last six years. The legal profession should make it clear that drafting and processes of the kind exemplified in the Simpler Regulatory System Act is not to be tolerated. Those instructing Parliamentary Counsel must lift their game. One wonders whether part of the problem might be the transfer of responsibility for corporations legislation, in the second half of the 1990s, from the Attorney-General's Department to Treasury. Would there be a better understanding that incompletely debated policies, reflected in badly drafted legislation, actually undermine the efficacy of important commercial rights, and therefore economic efficiency, if responsibility for the process is transferred back to the lawyers of Attorney-General's?
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